The Problem

Bootstrapping a business is hard. We rightly admire entrepreneurs who build products, teams, businesses, and companies without any outside investment. It’s hard, but for many, it’s worth the challenge. Bootstrapping a business is one of the few ways for founders to retain total control of their organization, set their own goals and priorities without answering to investors or a board of directors. It’s no coincidence that many of the companies pushing the boundaries on non-hierarchical management structures, radical transparency, and remote work are bootstrapped. As a result of this freedom to experiment and question the dogma of how businesses are built, the “bootstrapper community” of entrepreneurs has developed a collective set of values, priorities, and strategies well beyond the narrow definition of: not taking any outside capital.

And yet, here is a reality that we know from the 1,000s of accelerators and early-stage seed funds: A little bit of capital, a runway of full-time focus, a network, and access to high-quality mentors can help talented, ambitious founders launch great businesses.

But here’s the big problem. Venture capital firms invest with the intent of placing many bets, hoping that a few of their portfolio companies grow into enormous hits–the theory is that even though 80% of the businesses may fail, the few home runs will return the fund. In this model, only massive growth and outlier outcomes qualify as a success and even successful profitable businesses can be a “failure” for the fund3. This approach severely limits options and outcomes for founders and results in misalignment when founders can’t or don’t want, to build venture scale businesses.

As Rand Fishkin, founder of venture-backed Moz, concludes in Lost and Founder:

Unless your business is in alignment with the venture model of investing in many failures to find a small handful of absurdly successful mega-winners, this path is not for you.

Virtually all accelerators and seed funds have built their business models around getting their companies funded by VCs. Thus they invest on terms that make sense if you intend to raise multiple rounds of venture capital, but are completely out of sync with the way most founders want to build a business. There is no source of capital that is aligned with founders who want to build a healthy, sustainable, profitable business. Accelerators and seed/angel funds can be very helpful for founders, but they all invest with a structure (convertible notes, SAFEs) that forces founders to seek more and more rounds funding and ultimately to exit the business. Even investors who just take normal equity have mostly built their business models around funneling you into the venture capital food chain and a majority focus exclusively on getting as many of their companies to the next round of funding.

So many founders either:

Join an accelerator or raise seed funding, and later regret it because they actually wanted to build a healthy, profitable business with happy customers and happy employees. The reality is that by taking institutional/VC investment they’ve signed their company and their futures up for the “hyper-growth or die trying” freight train.

Or they just realize there are no sources of capital out there aligned with their goals and decide to be a bootstrapper by default.

Tons of aspiring founders limp along, work nights and weekends, make incredibly slow progress, burn out and do serious damage to their own mental and physical health and that of their families.

Even these options are just not available to many talented people with enormous potential. Maybe they have a family to support and can’t take on the risk. Maybe they didn’t come from privilege, had to fight like hell for their first job in tech, and have no clue if there will be a career opportunity waiting for them if they burn through their life savings on a startup that fails. Maybe they have the same motivations of basically every other founder that applies to YCombinator or raises an angel round except they just don’t want to be a part of the VC-startup culture.

The Solution

Earnest Capital is on a mission to change this. We are building an investment structure and a community of founder/investors who are aligned with the goals of founders who want to build real profitable sustainable businesses.

We’re building it the only way we know how to build things: transparently and with the help of this amazing entrepreneurial community. Here we want to introduce our current thinking on how we can improve the investment process and genuinely offer a viable form of capital for businesses that want an early-stage investment and mentorship to grow, but don’t want to take venture capital.

We believe that some early stage capital—where you raise one round and then sprint towards profitability—and having smart, experienced people literally invested in your company’s success… is good. It’s not for every founder, but there are going to be a lot of cases where it’s a win for both our fund and the founder.

Our attempt to crack this problem comes in two parts:

An investment structure that aligns investors and founders toward the same outcome. If you build the next Basecamp, Buffer, Wildbit or Wistia, then it’s a win for everyone.

A network of investors and mentors that get it. They understand that businesses like this can become very successful profitable businesses and can be built in a more sustainable way with a much lower likelihood of bursting into flames than your typical startup.

This post is about the first part. More on the second soon.

Goals for a new investment structure

First and foremost, our strategy at this stage is not to get too attached to any one particular term, but to operate from a set of goals and principles. We know there will be a lot of questions, a healthy amount of skepticism, and hopefully some great feedback. Our goals are:

Align incentives of both founder and investor to build a healthy profitable business that goes the distance.

Allow founders to grow the business at a sustainable pace while still generating a good return on investment.

Avoid the need to force further rounds of financing or a liquidity event (sale), while also leaving those options open if the founder chooses.

Explicitly acknowledge that founders and employees have a livelihood, family obligations and a life outside of their business. This is business, we’re investing and need to earn a return, but we believe that stress, burn out and overwork are more likely to kill your startup than not having your customer acquisition funnel fully optimized.

Clear intuitive terms that maximize options for the founder. We want to avoid perverse incentives for founders to make any weird decisions because a poorly thought out investment structure incentivizes them to do something that isn’t what they determine is best for the business and team.

We’re going to be investing early and some of our investments may actually decide they want to go the VC rocket ship route. That’s okay! We want to be thoughtful about making sure we can participate in that path and not be an obstacle.

The Term Sheet

The short version is that we will invest in companies with early-stage capital and provide mentorship from the awesome roster of investors in Earnest5. We will primarily be seeking to be paid back through cash dividends—a form of profit-sharing—when your business becomes profitable. We don’t take any equity or control in your business. The option to reinvest profits for growth, raise further financing, or sell the business, will all still be on the table. This is an investment structure by founders for founders on the terms we would have taken had they been available when were bootstrapping.

At this stage, this public document is just for discussion. All of the terms or figures are subject to change. Any specific figures would change significantly depending on the stage of the business, founding team and current levels of traction. So the structure is the important part we want feedback on. We’re hoping there will be a lot of good debate and discussion about various decisions made here so I wanted to walk through several of the key decisions in detail and in public.

At this point, I want to take a moment to thank the folks at Indie.vc and SparkToro for doing a lot of great thinking on this topic and making their deal documents public 6. We have borrowed liberally from their efforts and hope to build on them and contribute back in kind. I love this community.

One final point is that this is a not a process that will end in one single set of terms that is the only way we make investments. We may determine there should be multiple variations available or get creative on an individual deal.

1/ Our investment is repaid through cash dividends

The key difference from traditional early-stage startup financing is that we are not waiting for you to raise more financing (so those investors can buy us out) or eventually sell the business. We get paid through dividends because you build a profitable business. This aligns us with the main goal of so many founders today.

2/ The investor (us) receives dividends until the total amount hits the Return Cap

Basically, we’re going to invest $Y upfront and you pay us back dividends until we get X * $Y back. This is key to our ability to raise capital from outside investors. The reality is that there are not enough bootstrapped founders of technology startups who have accumulated enough capital to make this a real viable alternative to VC/Accelerators, we need to convince normal investors that this is a good use of their capital and the Return Cap is how we do that.

3/ Take a Percentage of Founder Earnings

We will sometimes use the term lower-case-P profit, but the reality is that for tax reasons, private businesses may be incentivized to show as little Profit as possible. So we’re defining the term Founder Earnings which is basically Net Income + any founder salaries that exceed a certain cap.

There are two obvious follow-ups. What’s the percentage? Well, it’s higher than it would be for equity. So if you thought that for X investment, you’d give up 15% in normal equity (which claims a % of dividends forever) then you’d expect to pay maybe 30-40% of Founder Earnings because that only lasts until we hit the Return Cap. Second, salary caps, wait… what? See below.

4/ Reasonable Founder Salaries

We don’t actually set the salaries. If the founders want to pay themselves $500k a year and have no corporate profit, that’s fine, but any salary amount above a certain (low but fair) threshold is added back into Founder Earnings and we get a percentage of that in dividends. The point here is we want to acknowledge that paying themselves a reasonable salary to cover the cost of living comes before any repayment to investors.

5/ What happens after the Return Cap is paid back?

Well, actually there are a few options here and we’re open to your feedback.

One option is, that’s the end of it. Once we get our Return Cap, then we’ve recouped our investment, you don’t make any more payments to us, we don’t own any portion of your company and that’s that. Earnest is a fund composed of founders and this is the structure we started from. However, this does have two downsides: (1) it forces us to be more aggressive on how high the Return Cap is and what percentage we take of Founder Earnings. If our upside is completely capped then we need to do all we can to make sure we get a good return out of it. (2) we hope that Earnest will bring more than just cash and be a valuable partner. We’re building an incredible roster of founders who will be invested in and mentor Earnest companies. If there’s a hard stop on the investment, then Earnest and its team will no longer be invested in the success of the company.

A second option, based on the reasons above, is that we still maintain a small stake in the company even when the Return Cap is repaid. The upside is that Earnest stays invested in your business, and we can be a little more relaxed on the other terms of the investment. The downside is that you’re giving up a long-term stake in the business.

What do you think founders? Which option would make more sense for you?

6/ If you raise further financing, our investment can convert to equity

Some founders may decide later that they want to raise more funding. In that case, we are basically using best practices from the startup world. Our investment will come with an option for us to convert into an equity stake based on whatever terms (see details below) you negotiate with the next round of investors.

Here are a few key decisions we made:

No initial valuation. We have opted for a convertible structure that doesn’t require us to actually agree on a valuation of the business at the time we invest.

No discount. Frequently these kinds of equity conversion terms (like convertible notes or a SAFE) will include a discount of 20% or so. So if the next investors buy in at a $2m valuation, our investment converts at 20% off of the $2m or a valuation of $1.6m. We are leaving this off to keep things simple.

With a Valuation Cap: This is useful in the instance where one of our investments decides to reinvest all their profits for a long time. In this scenario, they grow and grow (which is good) but they don’t make any dividend payments to Earnest (not ideal). If many years later that business decides to raise a round of investment or sell the business, we should participate at preferential terms in exchange for taking the early risk. So there is a cap and if you raise a round at a higher valuation than the cap, our investment converts at the cap.

Use any unpaid amount of Return Cap as the basis for conversion. This is the only significant difference between what we offer and a standard startup structure. If you decide the best move for the company is not to be profitable but to reinvest and raise more financing, that’s ok, we support it, but it is not really the main way we’d like to invest. So instead of using the amount we invested as the basis for conversion, we use any unpaid amount on the Return Cap. In simple numbers, if we invest $100k with a 4x, or $400k Return Cap. The company pays back $100k, so there’s $300k left to pay, then decides to raise a round. We base our conversion on the $300k remaining to be paid, not the $100k we invested.

7/ What happens if the company is sold?

We either (1) get paid any unpaid amount of the Return Cap. Most likely if the business is sold fairly early or (2) convert to equity first per the terms above and then get our share of the final sale price. This is more likely if the company grows a lot without making any dividend payments and then is sold.

How does this get us to our goals?

Incentives are completely aligned for the founder to grow a profitable business. If you build the next Basecamp, Buffer or Wildbit, it’s a success for both the founders and the fund.

It is patient capital. Unlike debt with a fixed repayment schedule, we collect our dividends at exactly the same time that the founders decide the business can provide them.

It maximizes the founders’ options at each stage of the company. When investing in a company at the early stage, it may not be clear whether it makes more sense for the company to be on the path to profitability to be a long-term growth company, reinvesting as much as possible and raising future financing. Most accelerator investments are structured to force you into being a growth company, we didn’t want to make the inverse mistake where we force companies to try to take profits. We believe this structure allows the founder the maximum flexibility to choose what’s best for the business while allowing us to participate and earn a reasonable return for our investors.

Is it clear and intuitive? I think there is room for improvement but in general, we are willing to have some upfront complexity in the deal to make sure that it leads to intuitive decision making further down the road. Obviously “we give you money and take 20% of your company” is technically simpler, but doesn’t align investors with a company that you never intend to sell and can create unintuitive or perverse incentives later down the road.

How does this compare to normal equity, where the investor owns a percentage of your company, to you?

How does this compare to convertible notes or SAFEs?

Are the cash repayment terms clear?

Are the equity conversion terms clear?

How important is the idea that eventually our investment would wrap up without the founder having to sell the company. For example our investment automatically concluding after receiving a certain amount of dividend share versus a normal equity investment which has the rights to a certain % of profit share in perpetuity.

Put another way, which would you prefer for the same amount of investment: